Monetization Demystified

There is a lot of talk (finally) about how the Fed is simply "printing money" to pay for the unprecedented increases in spending and deficits. Economists are going on about how Bernanke's monetizing the deficit. Is this is the same as "printing money"? And, how is this different from borroing by Uncle Sam via the Treasury?



Here is a Monetization primer that will hopefully clarify exceptionally important issues - especially given the US is well into non-sustainable deficits.

The Treasury

When the Treasury borrows from domestic and foreign (Chinese) lenders, it issues new government debt: Treasury bonds and Notes. This borrowing used to be done at four large auctions every year - now they are almost a weekly feature. This borrowing finances "G" - government spending.

If the Treasury finds no lenders - or insufficient lenders - it has to simply "sell" these new government bonds to the Federal reserve which "pays" for these by simply creating money out of this air. This is known as "monetization" of government deficits and is extremely dangerous. On a large scale - as it inevitably is - this leads to hyperinflation. Note: Since President Nixon closed the "gold window" in 1971, there is no more gold anchor. Since 1971, there has been nothing restricting the creation of money by the Federal Reserve.

The Fed

To increase money for normal operations (i.e. not for monetizing the deficit), the Fed simply buys previously issued (not new) Treasury bonds from local banks and creates money to increase the growth of the monetary base and to lower short-term interest rates known as the Federal Funds Rates. To shrink money in circulation and to raise the short-term rates, the Fed sells government bonds to local banks - it reverses the process. These are Open Market Operations, not to be confused with Monetization.

Since Fall 2007, the Bernanke Fed has bought Trillions in toxic debt (rotten mortgages) from financial institutions, etc. Including, by way of example, this empty shopping mall in Oklahoma City (yes, believe it):


Empty Shopping Mall in Oklahoma City owned by the Federal Reserve

This process has been labeled the great "Stealth Monetization" by the Fall 2007 Rutgers EMBA class.

This monetization went largely unnoticed, and most important, this is a "toothpaste" monetization. Like toothpaste, this money is easy to print and impossible to put back. When the time comes to shrink the monstrous amount of money created by the Fed - unprecedented in human history - we will be unable to"vacuum back" this money creation. Who will buy back the toxic debt? Certainly not the same financial institutions that were delirious when the Fed took it off their hands at above-market value. This is the new and more insidious monetization that has cropped up since 2007.

Hopefully this clears up the confusion between Government spending, Open Market Operations, and Monetization - both conventional and stealth.


Farrokh Langdana, Ph.D.
Rutgers University Business School

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